Issuance of catastrophe bonds reached a new record in 2014 as rising demand for relatively high yields pushed insurers to do more and larger deals to offload an ever wider variety or risks from natural disasters.
As of Dec. 18, $8.03 billion of catastrophe bonds were sold, according to reinsurance broker Aon Benfield. Even before a few additional deals likely to close by year’s end, that tops the previous record of $7.86 billion, reached in 2007. And it brings the total amount of catastrophe bonds outstanding to more than $22 billion.
Aon Benfield estimates that issuance of collateralized reinsurance — privately negotiated reinsurance policies in which capital market investors participate —also captured record volume, jumping more than 20% to $36 billion as of June 30.
The figures reflect the widening appeal of these instruments. Pension funds and other institutional investors are increasingly entering the market, pumping up the assets under management of money managers dedicated to the asset class, such as Nephila Advisors, Leadenhall, Securis Investment Management and Elementum Advisors. Although spreads on ILS have narrowed over the last few years, they’re still attractive compared with high-yield corporate bonds.
“We think [the record volume] is largely a function of capital from other sources like traditional fixed-income investors and other institutional money managers who are moving into the cat bond market as they search for yield,” said John DeCaro, founding principal and portfolio manager at Chicago-based Elementum Advisors. “They’re looking at cat bonds as a cheap proxy for taking on high-yield exposure.”
Market dynamics, however, are changing. At the start of 2014, Elementum calculated the weighted average spread for cat bonds issued in the Rule 144A market to be 582 basis points, while the BofA Merrill Lynch US High Yield BB Total Return Index’s average spread was 264 basis points. And the risk premium for cat bonds is even higher than what’s suggested by the 318 basis-point spread between the two asset classes. That’s because high yield bonds tend be quite a bit longer— the current average maturity in the Merrill index is 7.1 years vs. 1.76-year-average for cat bonds, according to DeCaro.
But the average cat bond spreads fell to 535 basis points in mid-December, when the high-yield index rose to 351 basis points, reducing the premium to invest in less liquid and more complex cat bonds to 184 basis points. If high-yield spreads remain elevated, cat bonds are likely to lose some of their luster, especially given their increasing tendency to include new and unmodeled risks.
Morton Lane, president of cat-bond consultancy Lane Financial, noted that, as interest rates have started to creep up, the spread between investment-grade and high-yield bonds has widened considerably. According to Lane Financial’s models that spread movement provides a minimum charge for ILS coverage.
“So we think the [risk] premiums we’ll see for ILS, which otherwise might have drifted lower, may go sideways and even up,” Lane said.
He nevertheless foresees ILS volume remaining steady given the continuing influx of new investors, adding that coincidentally he had just received an email from an investor now entering the market who had first queried about it two years ago.
William Dubinsky, head of insurance-linked securities at Willis Capital Markets & Advisory (WCMA), said his firm anticipates ILS volume continuing to grow if at a slower rate, as tight spreads continue to draw more issuers but dampen demand for risk. He anticipates increasingly innovative deal structures that give investors exposure to less commoditized levels of risk, and therefore offer richer spreads, and make deal terms more attractive from a capital market perspective.
“More importantly, without steady structural innovation, the part of the market the investors can access can only grow so much,” Dubinsky said. “We do expect to see steady innovation . Whether it’s enough is an open question.”
New ILS investors, however, must be prepared to approach the level of underwriting that reinsurers have long performed, because transactions are becoming increasingly longer duration and more complex. Weighted average maturities have stretched to more than 3.55 years at issuance in deals placed in 2014, from 3.28 years a year ago, and deals are regularly structured to aggregate losses to reach the payout trigger point, rather than relying on a single occurrence. They’re typically structured as indemnity transactions, which cover actual losses and allow issuers to include an ever-wider range of business lines, across geographies and peril types. The $95 million RiverFront Re cat bond in March from Great American Insurance, for example, includes equine mortality and trucking.
DeCaro noted the risk associated with newer lines of business usually isn’t modeled.
"That’s a function of a soft market environment, but the problem becomes how do you come up with the expected loss, since those risks aren’t modeled,” DeCaro said, adding, “And if a storm happens in an unexpected place, you could end up losing money because horses die from a tornado in Kentucky when an investor thinks he or she is exposed to hurricane risk.”
Mind the Risk
More opportunistic investors without the resources or expertise to perform adequate due diligence appear to have crowded into deals to take advantage of their attractive rates, including those with new issuers and structures, only to discover the transactions prove to be riskier than anticipated.
American Strategic Insurance Group’s Gator Re was upsized by 60%, to $200 million, when it priced aggressively at 6.5% in March. Issued in a single tranche, the transaction’s first-ever structure provided exposure to U.S. hurricanes and severe thunderstorms on a per-occurrence and indemnity basis, as well as exposure to aggregate losses of just severe thunderstorms.
The aggregate losses have added up, and investors have reported that they are within the 10% indemnity trigger, according to the Artemis website that tracks the ILS market, resulting in a payout if less than $15 million in losses occurs before year-end.
Notably, Gator Re reached such a precarious state in a year with the least damage in decades from tropical storms, but investors in such deals may be less fortunate in 2015. Munich Re calculates 2014’s total insured losses for tropical storms around the world at $2.7 billion, despite six out of eight Atlantic storms reaching hurricane status, and that’s much lower than the $24 billion average loss over the past 10 years, or $12 billion average over the last 30 years.
Securis Investment Partners manages over $3 billion in assets, tripling in size over two years, and within the catastrophe space it now focuses on collateralized reinsurance where it sees more value, according to Rob Proctor, one of the firm’s founders. More straightforward and commoditized cat bonds have seen not only much tighter spreads but the inclusion of more risk. Even regular issuers such as USAA have a wider range of risk coverage; its most recent Residential Re transaction for $100 million, which priced in November, includes obscure risks such as meteorite impact and volcano.
“Bond issuers are saying, If we can include those risks why not,’” said Procter. “It’s a typical sign of a soft market . more [perils are] getting thrown in for the same price or an even lower price.”
In the year ahead, peril coverage may be sought in geographies that until now have been rare or nonexistent in the ILS market, as well as those of a manmade nature. Issuers and investors are now frantically discussing the renewal of collateralized reinsurance transactions, and according to Procter there’s been increasing talk about the inclusion of terrorism risk.
"This is hard to define, because every transaction is different, but there’s growing discussion of more risk associated with potential terror events being included in transactions,” Procter said. “There’s a loosening of terms, whereby terrorism events are more likely to be covered now than they were in the past.”
He added that such language may still be carved out of the final terms, “But the point is there a trend of looser terms and other risks being included.”
Another example, Procter said, is natural catastrophes in geographies that have largely been left uncovered by the ILS market. He said Securis has been talking to Chinese insurers, and it may commit to such transactions.
“There are a number of issues, such as the available models, how to quantify market losses, and so on,” Procter said, adding that one of the “great hopes” of the ILS market has been to cover natural catastrophes in new parts of the world. “There’s some evidence that may be starting to happen. Conceptually it makes complete sense.”
Even if investor demand for ILS wanes somewhat next year, it may still be an attractive time for insurers in geographies now largely uncovered by the ILS market to make an entryway.
“The cat bond market now is providing little if any differentiation in spread between, say, European wind and Japanese earthquake bonds, because investors are hungry for diversification away from U.S. wind (hurricane) risk,” DeCaro said, adding, “It’s an opportune time for Asian companies to come to the cat bond market where they can experience the benefit of full collateralization and terming out their reinsurance protection.”